Legal Definitions - Section 1244 Stock

Section 1244 Stock refers to shares in certain small businesses that receive special tax treatment under Section 1244 of the U.S. Internal Revenue Code. This provision allows investors who experience a loss when selling these specific shares to treat a portion of that loss as an ordinary loss rather than a capital loss. This distinction is crucial because ordinary losses can typically be deducted against a wider range of income, offering a more significant tax benefit compared to capital losses, which have stricter deduction limits.

Normally, when you sell stock at a loss, it's considered a capital loss. Capital losses can only be used to offset capital gains (profits from other investments) and a very limited amount ($3,000 per year) of your regular income, like your salary. Any remaining capital loss must be carried forward to future tax years. However, Section 1244 stock allows eligible investors to treat up to $50,000 of their loss (or $100,000 for married couples filing jointly) as an ordinary loss. Ordinary losses can be fully deducted against any type of ordinary income in the year the loss occurs, providing a more immediate and substantial tax advantage.

For stock to qualify as Section 1244 stock, it must meet specific criteria at the time it was issued:

• It must have been issued by a domestic corporation.
• The corporation must have been a "small business corporation" when the stock was issued, meaning the total money and other property received by the corporation for its stock did not exceed $1,000,000.
• More than 50% of the corporation's gross receipts during its most recent five taxable years must have come from active business operations, not from passive sources like rent, royalties, or dividends.
• The stock must have been issued directly to the individual claiming the loss (or a partnership that then distributed it to the individual).

This provision is designed to encourage investment in new and growing small businesses by reducing the financial risk for investors if the business doesn't succeed.

Examples of Section 1244 Stock in Action:

• Scenario: Sarah, an experienced software engineer, invests $75,000 in a promising new mobile app startup, "InnovateNow Inc.," which meets all the criteria for a small business corporation under Section 1244. She receives common stock directly from the company. After two years, despite significant effort, the app fails to gain traction, and InnovateNow Inc. declares bankruptcy, rendering Sarah's stock worthless.

  How it illustrates Section 1244 Stock: Because Sarah's investment qualified as Section 1244 stock, she can treat $50,000 of her $75,000 loss as an ordinary loss on her tax return. This allows her to deduct that $50,000 directly against her regular income (like her salary), significantly reducing her taxable income for the year. If it were a standard capital loss, she would only be able to deduct $3,000 against her ordinary income per year, carrying the rest forward.

• Scenario: David, a retired executive, decides to invest $40,000 in "GreenThumb Landscaping," a local startup founded by a young entrepreneur. GreenThumb Landscaping is structured as an eligible small business corporation, and David receives stock directly. After three years of operation, the business faces unforeseen competition and economic downturns, leading to its closure and David's stock becoming valueless.

  How it illustrates Section 1244 Stock: Since David's investment in GreenThumb Landscaping qualified as Section 1244 stock, he can claim his entire $40,000 loss as an ordinary loss. This allows him to offset this loss against his pension income or other investment income, providing a much greater tax benefit in the year of the loss than if it were treated as a capital loss, which would have much stricter deduction limits.

• Scenario: Maria and Carlos, a married couple filing jointly, invest $120,000 in "Artisan Bakehouse LLC" (structured as a corporation for tax purposes), a new bakery started by their niece. Artisan Bakehouse meets all the requirements for a small business corporation under Section 1244. After a few challenging years, the bakery is forced to close, and their investment is lost.

  How it illustrates Section 1244 Stock: As a married couple filing jointly, Maria and Carlos can treat up to $100,000 of their $120,000 loss as an ordinary loss. This means they can deduct $100,000 against their combined ordinary income (e.g., salaries, interest income) in the year the loss occurred, providing a substantial reduction in their overall tax liability. The remaining $20,000 would be treated as a capital loss, subject to the usual capital loss limitations.